Tournament Theory

Economic theory traditionally explains income differences
in terms of marginal
productivity. If we have a mason who can lay 50 bricks
per hour, we expect him to earn twice as much as the mason
who can lay only 25 bricks per hour because there would be a
profit opportunity for building contractors if any other
wage rate existed. If the more productive mason works for
less than twice as much as the other, everyone would want to
hire him and no one would hire the less-productive one. Only
when his wage is exactly twice as high, exactly paralleling
the difference in productivity, would people be equally
willing to hire either.

This way of explaining wage differentials suggests that
the very large differences in income are the result of
equally large differences in performance. However, there is
an alternative explanation that says that in many cases
relative differences in performance, not absolute
differences, determine earnings. This explanation of wage
differences in terms of relative performance is often called
tournament theory. One place where this explanation
should work is in contests with winners and losers. For
example, consider two almost equally able gladiators
fighting in the arena of ancient Rome. Small differences in
ability (or luck) could result in a huge difference in
reward--one could die and the other live.

Though gladiators are no longer part of our world, there
are still cases in which winners matters a lot, and as a
result, small differences in ability (or luck) can cause
large differences in reward. The sports world has many
examples. The winner of Olympic gold may triumph by a tiny
fraction of a second, but that tiny fraction often is
translated into huge amounts of money via product
endorsements. The practice of law also has winner-take-all
situations. The level of a lawyer's skill may be less
important than how he ranks relative to other lawyers with
whom he competes.

We have limited amounts of time to read, enjoy music, or
attend movies. Given our limited time, we are selective and
willing to pay a substantial premium for a product that is
better. Of the many talented pianists, only the top few earn
enough to live by concert performances alone, but they earn
substantial sums. Two writers may be nearly equal in talent,
but when people have a limited amount of time to read, the
vast majority may end up reading the work of the one that is
only slightly better. Though at first glance these
situations seem very different from those involving
athletics, the way that pay is determined may be very
similar.

Another place where relative ability may matter a great
deal is in the managerial ranks of corporations. There are
only limited numbers of promotions available, and they are
usually determined by relative performance. Only one person
can be CEO of a company at a time, and small differences in
ability among those contending for the top spot can result
in large differences in rewards. Further, it may be in the
interests of the company to structure pay so that the winner
makes very large sums as a way of spurring on those lower in
the hierarchy. The primary reason for the high pay given to
the CEO may be to give those lower in the hierarchy an
incentive to work hard, not to give the CEO himself the
incentive to perform well.